Economic effects of VAT reforms in Germany

Abstract

In the tax policy debate, differentiation of value-added taxes (VAT) is often justified by distributional concerns. Our quantitative analysis for Germany indicates that such concerns are misplaced. We find that the abolition of VAT differentiation has only negligible redistributive effects. Instead, reduced VAT rates are found to act as industry-specific subsidies. Whereas the overall welfare effects of pure VAT reforms are very small, a revenue-neutral introduction of a harmonized VAT combined with reductions in the marginal income tax rates or social security contributions turns out to yield substantial welfare gains for all households.

Acknowledgement

We thank three referees of this journal for helpful comments.

Notes

¹ In the public finance literature a number of reasons are mentioned why VAT differentiation might be justified under efficiency considerations: (i) administrative and compliance costs (Keen and Mintz, 2004), (ii) the role of the shadow economy, (iii) differences in price elasticities of goods or (iv) complementarity of consumption goods with untaxed leisure activities. More recently, VAT reductions have also been proposed as a measure to stimulate employment in labour intensive service industries (Holmlund, 2002).

² Other issue-driven modifications of the standard model include recent analyses of climate policy (Böhringer and Lange, 2005) and labour market regulations (Böhringer et al. 2005).

³ Exports and imports include both goods and trans-border capital services.

⁴ Cf. e.g. Biewen (2000) or Atkinson et al. (1995, p. 18) for alternative scales.

⁵ Tax rates are reported relative to gross factor income.

⁶ The data underlying Table 3 has been provided by the German federal statistical office in the form of a special Z-matrix differentiated by VAT rates.

⁷ Price elasticities of food consumption in the same range have been identified for a number of countries more recently by Selvanathan and Selvanathan (2006).

⁸ It should be kept in mind that SSC are levied only on labour, whereas income taxes are levied on both labour and capital. See the discussion at the end of Section ‘Distributive effects and efficiency’.

⁹ Equivalent variation captures changes in all utility-generating items (Fig. 2), including leisure.

¹⁰ The theoretical literature on optimal taxation suggests that the excess burden of capital taxation is higher than that of labour taxation (e.g. Chamley, 1986, Atkeson et al., 1999).

¹¹ A detailed table of industry level results is available upon request.